Views on "The Distressing Gap"

[Note: Bill McBride is the economist behind the Calculated Risk weblog. Bill regularly updates the phenomenon that he calls “The Distressing Gap”, which tracks the increasing divergence between new home sales and sales of existing single-family homes; Bill states the gap as a percentage of new-to-existing, while I restate his numbers as a ratio. Dating back to almost the mid-point of the past century, the percentage/ratio of new-to-existing has maintained a very narrow range; in 2007, the gap started to increase, and it is now triple the historic pattern. This is an excerpt of yesterday’s exchange between myself and John McManus, who is the editorial director at Big Builder for Hanley-Wood.]

JM: I’m thinking you’re thinking “scarcity” won’t likely act as much of a force of nature in this thing. Do you think there’s a point at which investor buyers of distressed properties, REO, and short sales (which count in the ratio) will start to tail-off? Or, is it worth looking at individual buyers (with a loan) of “normal” resales in a ratio with new?

Is there any learning (for new home builders) to take out of that approach on the ratio?

FG: I suppose, if what we see now is a structural change in homeownership, then there could be a persistent new normal at a significantly lower level of demand for for-sale housing. I don’t discount that possibility as much as I once did, but I don’t really know.

If I read his analysis the way I think he intends, Bill McBride tends to attribute problems in home sales – months of supply, falling prices, whatever – to oversupply. I think supply in the absence of demand is irrelevant. Or, at least, I think over-supply is secondary to insufficient demand. Right now, we are probably not even replacing the existing housing that is being taken out of stock. With one important caveat, I think the current amount of oversupply is a product of a persistent lack of demand, and that one caveat is that the supply is also heightened by economic distress.

I was speaking with a Realtor some time back, and she made the comment that – by some measure – every property for-sale today can be considered a distressed sale, because, if circumstances didn’t require it, no one would be selling homes at current prices. But, the circumstances that require owners to sell outnumber the circumstances that allow owners not to sell. So – yes – that caveat allows you to say that there is some excess supply, but that supply is also not being offset by coincident demand; except for first-time buyers (who have nothing to sell) and last-time sellers (who have no need to buy), and excluding second-home buyers, homes that are sold are normally replaced with homes that are bought. Now, they cannot or they will not purchase. So, supply lingers.

Housing (and the subset of homebuilding) is a system; systems are comprised of the cause-and-effect relationships between a system’s interdependent parts, and it needs to be understood as such.

Scarcity is a supply metric; something is only scarce because there is more demand for a product than there is availability. In the absence of demand, scarcity will not materialize, unless something dramatically reduces the supply (if no one needs to sell or wants to sell). Something is interrupting the elasticity of supply and demand. In the case of housing, why is demand so insensitive to price or affordability?

Regarding investors. Because of yields, I think investors are being driven to real estate for a portion of their portfolios. It’s not like they stand to make higher returns elsewhere. I don’t think they prefer real estate. I think the proportions are probably high, and the moment other investment yields become more viable, there will be a significant drop-off in real estate investment, and that may coincide with higher prices and lower yields on the then-available residential investment.

As far as the ratio of new home sales to sales of existing homes, I suppose, given the high proportion of sales to investors, maybe we should consider backing them out. But, cash sales are occurring with both users and investors. I think the story – the real story – of this ratio is that, for more than a half-century, this ratio remained in a very tight range (roughly, 1:5 or 1:6), through all kinds of economic conditions and housing markets; that ratio dramatically diverged in 2006, the divergence has steadily increased, and it has not returned.

Currently, the ratio stands at almost 1:16. Why?

Demand is the result of something. What drives it? Some of it is social, some of it is financial, all of it is dependent on some collective amount of individual willingness and ability.

One of my favorite scenes from “Cheers” is when Norm, being alternately threatened and bribed, declares, “You don’t scare me, and I can’t be bought”. He thinks for a second, and adds, “You put the two together, and I’m your man!” You put absence of demand with elevated levels of reluctant supply, both driven by the extraordinary economic conditions, and this picture is what you get.

I am not an economist. Bill McBride has forgotten more than I ever knew. But, I have been through every one of these economic cycles since 1974 – as a lender, as a builder, as a consultant – and this is how I see the current situation.